IRS audit initiatives.

In 2000, the IRS projected that abusive tax shelters accounted for about $5 billion in lost revenue, and began to suspect that this was just the tip of the iceberg of schemes to defraud the government of tax. To combat abuse, the IRS is using its newly realigned audit resources to focus on key areas of noncompliance (FS 2202-12, 9/16/2002). Under this strategy, it is concentrating first on promoters of various abusive schemes, shelters and trusts, then on participants in such arrangements.

The Service's revamped compliance program is using a full scope of tools and techniques, ranging from summons enforcement, injunctions and criminal investigation of abusive-scheme promoters, to civil audits of participants.

Even with its concentration in several problem areas, the IRS will keep a presence in other audit areas to maintain its core tax administration responsibilities. Additional examination resources will help it to meet this requirement.

Key Problem Areas

The Service is directing more resources to six priority areas; 2003 is a transition and training year, as new audit cases move into the IRS system. These areas include:

* Offshore credit card users;

* High-risk, high-income taxpayers;

* Abusive schemes and promoter investigations;

* High-income nonfilers;

* Unreported income; and

* The National Research Program (NRP).

Offshore Credit Card Project. Although having an offshore credit card is not illegal, some people are using credit cards to evade U.S. taxes. The cards give taxpayers easy access to offshore funds and accounts in tax-haven countries,allowing them to hide income.

According to the IRS, there could be as many as two million U.S. citizens with debit/credit cards issued by offshore banks, compared with only 170,000 Reports of Foreign Bank and Financial Accounts filed in 2000. The IRS uses an extensive process to identify the taxpayer associated with the card, including an analysis of spending patterns, unusual expenses and various other factors.

From this information, it has already developed hundreds of cases for civil audits or potential criminal investigations and is increasing resources in 2003-2004 to devote to working these cases. (For further information on IRS efforts to curtail offshore credit card abuses, see Rosenberg, Tax Practice & Procedures "Amnesty for Offshore Tax Evaders," p. 226, this issue, and Godfrey, "Amnesty Participation Requirements," p. 228, this issue.)

High-risk, high-income taxpayers. High-income taxpayers have resources to use passthrough entities (e.g., partnerships, trusts and corporations), which often make their returns complex. Even the IRS's various matching programs cannot always verify income and deductions from such activities.

Although the IRS has begun to match K-1 forms for passthrough entities to individual returns, this technique does not verify the entity's reported income, which requires an examination. In trying to identify high-risk, high-income returns, the Service uses a combination of filters and is selecting returns with unreported income or structured transactions (i.e., transactions with a limited economic benefit that act primarily to reduce or eliminate a tax liability). These transactions are channeled through one or more passthrough entities to create paper losses that flow back to individual returns, offsetting income from other sources.

Abusive schemes and promoter investigations. IRS efforts to combat abusive schemes and scams (including the Offshore Credit Card Project) will significantly increase in 2003. Schemes and scams on the rise include:

1. Reducing individual tax liability by claiming inflated expenses, false deductions, unallowable credits or excessive exemptions.

2. Filing frivolous returns based on arguments that compliance is voluntary or that tax collection is not Constitutional.

3. Promoting slavery reparation claims to compensate taxpayers whose ancestors were slaves.

4. Setting up abusive shelters and trusts to hide income.

5. Using employment tax schemes (e.g., employee leasing, paying in cashand filing false payroll tax returns).

The Service is using fraud specialists to investigate each of these five groups. To identify and address promoter activity, it also created a Promoter Lead Development Center to systematically monitor the Internet to identify abusive activities and develop cases for injunctive investigations.

High-income nonfilers. The IRS is addressing nonfilers and focusing on the most egregious and high-risk segments of the population. It will pursue this on many fronts, including:

* Reengineered processes and work streams to improve efficiency and productivity.

* Identification and expedited assignment of the most egregious nonfilers.

* Expanded and centralized automated enforcement.

* Outreach and education efforts.

Unreported income. This area represents the largest component of the tax gap. The IRS had customarily used indirect examination methods to identify unreported income, because it had no systematic method for selecting the returns at highest risk for it, until now. It recently developed a tool, the Unreported Income Discriminant Index Formula (UIDIF), for identifying returns with a high probability of unreported income. Traditionally, it assigned a DIF score to all individual returns, to determine the probability that return information was incorrect. The new UIDIF score, however, rates the probability that income was omitted from a return. The IRS is using both indexes to score all returns.

NRP. NRP examinations measurereporting compliance and identify issues. The program will improve the examination selection process. NRP is very different from its predecessor, the Taxpayer Compliance Measurement Program. Unlike that program, NRP does not rely heavily on time-intensive, "line-by-line" audits for establishing a baseline measure of reporting compliance.

The IRS has not conducted updated research on the distribution of errors on returns for more than 13 years, a period in which the economy and the tax law have changed dramatically. NRP gives the IRS the ability to direct examinations and other compliance activities with accuracy and precision and will prevent thousands of "no change" audits each year.

NRP will review a small, statistically valid sample of individual returns for tax year 2001--less than 50,000 returns out of 132 million individual returns filed. The program has four main categories:

1. No IRS contact. About 8,000 returns will be checked, relying solely on information already available to the IRS.

2. Correspondence. This is a less intrusive exchange with taxpayers than the old standard of sit-down audits. About 9,000 returns will be included in this process.

3. Less intrusive audits. Instead of the old "line-by-line" examination approach, the IRS will gather more information in advance from agency records and focus only on selected parts of approximately 30,000 returns.

4. Calibration audits. These will consist of about 2,000 examinations that will check each line of a return. In a major change from earlier programs, however, taxpayers will not have to provide line-by-line substantiation.

Conclusion

The IRS has set out an ambitious program to improve tax collection and end abuses. Due to the magnitude of the amounts involved in tax fraud, practitioners can probably expect a significant initiative, requiring them to increase their focus on aggressive tax planning strategies.

FROM BRADFORD G. CARLSON, QUINCY, MA